Unit III Unit III

Capital Budgeting Capital Budgeting

Decision Criteria Decision Criteria
7#
Leaning Objective Leaning Objective
Why Decision? Why Decision?
Planning Ior Iuture investments Planning Ior Iuture investments
What Decision? What Decision?
Mutually Exclusive, Accept Reject, Mutually Exclusive, Accept Reject,
Independent or Capital Rationing Independent or Capital Rationing
How How - - Process Process
Capital Budgeting Capital Budgeting: : the process of the process of
planning for purchases of long planning for purchases of long- -
term assets. term assets.
example example: :
Suppose our firm must decide Suppose our firm must decide
whether to purchase a new plastic whether to purchase a new plastic
molding machine for $125,000. How molding machine for $125,000. How
do we decide? do we decide?
Will the machine be profitable? Will the machine be profitable?
Will our firm earn a high rate of Will our firm earn a high rate of
return on the investment? return on the investment?
Decision Decision- -making Criteria in making Criteria in
Capital Budgeting Capital Budgeting
How do we decide How do we decide
if a capital if a capital
investment investment
project should project should
be accepted or be accepted or
rejected? rejected?
%he Process %he Process
Idea Generation Idea Generation
Market Research Market Research
Identification of the Project Alternatives Identification of the Project Alternatives
Selection of the Project Selection of the Project
Implementation Implementation
Feedback Feedback
%he Ideal Evaluation Method should: %he Ideal Evaluation Method should:
a) include a) include all cash flows all cash flows that occur that occur
during the life of the project, during the life of the project,
b) consider the b) consider the time value of money time value of money,,
c) incorporate the c) incorporate the required rate of required rate of
return return on the project. on the project.
Decision Decision- -making Criteria in making Criteria in
Capital Budgeting Capital Budgeting
Payback Period Payback Period
%he number of years needed to %he number of years needed to
recover the initial cash outlay. recover the initial cash outlay.
How long will it take for the project How long will it take for the project
to generate enough cash to pay for to generate enough cash to pay for
itself? itself?
Payback Period Payback Period
How long will it take for the project How long will it take for the project
to generate enough cash to pay for to generate enough cash to pay for
itself? itself?
00 11 22 33 44 55
88
66 77
(500) 150 150 150 150 150 150 150 150 (500) 150 150 150 150 150 150 150 150
Payback Period Payback Period
How long will it take for the project How long will it take for the project
to generate enough cash to pay for to generate enough cash to pay for
itself? itself?
00 11 22 33 44 55
88
66 77
(500) 150 150 150 150 150 150 150 150 (500) 150 150 150 150 150 150 150 150
Payback period 3.33 years. Payback period 3.33 years.
Is a 3.33 year payback period good? Is a 3.33 year payback period good?
Is it acceptable? Is it acceptable?
Firms that use this method will Firms that use this method will
compare the payback calculation to compare the payback calculation to
some standard set by the firm. some standard set by the firm.
If our senior management had set a If our senior management had set a
cut cut- -off of 5 years for projects like off of 5 years for projects like
ours, what would be our decision? ours, what would be our decision?
Accept the project Accept the project..
Drawbacks of Payback Period: Drawbacks of Payback Period:
Firm cutoffs are Firm cutoffs are subjective subjective..
Does not consider Does not consider time value of money time value of money..
Does not consider any Does not consider any required rate of required rate of
return return..
Does not consider all of the project`s Does not consider all of the project`s
cash flows cash flows..
Drawbacks of Payback Period: Drawbacks of Payback Period:
Does not consider all of the project`s Does not consider all of the project`s
cash flows. cash flows.
00 11 22 33 44 55
88
66 77
(500) 150 150 150 150 150 (300) 0 0 (500) 150 150 150 150 150 (300) 0 0
Consider this cash flow stream!
Drawbacks of Payback Period: Drawbacks of Payback Period:
Does not consider all of the project`s Does not consider all of the project`s
cash flows. cash flows.
00 11 22 33 44 55
88
66 77
(500) 150 150 150 150 150 (300) 0 0 (500) 150 150 150 150 150 (300) 0 0
%his project is clearly unprofitable, but we
would accept it based on a 4-year payback
criterion!
Discounted Payback Discounted Payback
Discounts the cash flows at the firm`s Discounts the cash flows at the firm`s
required rate of return. required rate of return.
Payback period is calculated using Payback period is calculated using
these discounted net cash flows. these discounted net cash flows.
!74-028 !74-028
Cutoffs are still subjective. Cutoffs are still subjective.
Still does not examine all cash flows. Still does not examine all cash flows.
Discounted Payback Discounted Payback
00
11 22 33
44 55
(500) 250 250 250 250 250 (500) 250 250 250 250 250
Discounted Discounted
Year Year Cash Flow Cash Flow CF (14) CF (14)
00 - -500 500 - -500.00 500.00
11 250 250 219.30 219.30
Discounted Payback Discounted Payback
00
11 22 33
44 55
(500) 250 250 250 250 250 (500) 250 250 250 250 250
Discounted Discounted
Year Year Cash Flow Cash Flow CF (14) CF (14)
00 - -500 500 - -500.00 500.00
11 250 250 219.30 219.30 1 year 1 year
280.70 280.70
Discounted Payback Discounted Payback
00
11 22 33
44 55
(500) 250 250 250 250 250 (500) 250 250 250 250 250
Discounted Discounted
Year Year Cash Flow Cash Flow CF (14) CF (14)
00 - -500 500 - -500.00 500.00
11 250 250 219.30 219.30 1 year 1 year
280.70 280.70
22 250 250 192.38 192.38
Discounted Payback Discounted Payback
00
11 22 33
44 55
(500) 250 250 250 250 250 (500) 250 250 250 250 250
Discounted Discounted
Year Year Cash Flow Cash Flow CF (14) CF (14)
00 - -500 500 - -500.00 500.00
11 250 250 219.30 219.30 1 year 1 year
280.70 280.70
22 250 250 192.38 192.38 2 years 2 years
88.32 88.32
Discounted Payback Discounted Payback
00
11 22 33
44 55
(500) 250 250 250 250 250 (500) 250 250 250 250 250
Discounted Discounted
Year Year Cash Flow Cash Flow CF (14) CF (14)
00 - -500 500 - -500.00 500.00
11 250 250 219.30 219.30 1 year 1 year
280.70 280.70
22 250 250 192.38 192.38 2 years 2 years
88.32 88.32
33 250 250 168.75 168.75
Discounted Payback Discounted Payback
00
11 22 33
44 55
(500) 250 250 250 250 250 (500) 250 250 250 250 250
Discounted Discounted
Year Year Cash Flow Cash Flow CF (14) CF (14)
00 - -500 500 - -500.00 500.00
11 250 250 219.30 219.30 1 year 1 year
280.70 280.70
22 250 250 192.38 192.38 2 years 2 years
88.32 88.32
33 250 250 168.75 168.75 .52 years .52 years
Discounted Payback Discounted Payback
00
11 22 33
44 55
(500) 250 250 250 250 250 (500) 250 250 250 250 250
Discounted Discounted
Year Year Cash Flow Cash Flow CF (14) CF (14)
00 - -500 500 - -500.00 500.00
11 250 250 219.30 219.30 1 year 1 year
280.70 280.70
22 250 250 192.38 192.38 2 years 2 years
88.32 88.32
33 250 250 168.75 168.75 .52 years .52 years
%he Discounted %he Discounted
Payback Payback
is is 2.52 2.52 years years
ther Methods ther Methods
1) 1) Net Present Value Net Present Value (NPV) (NPV)
2) 2) Profitability Index Profitability Index (PI) (PI)
3) 3) Internal Rate of Return Internal Rate of Return (IRR) (IRR)
Each of these decision Each of these decision- -making criteria: making criteria:
Examines all net cash flows, Examines all net cash flows,
Considers the time value of money, and Considers the time value of money, and
Considers the required rate of return. Considers the required rate of return.
Net Present Value Net Present Value
OO NPV the total PV of the annual net NPV the total PV of the annual net
cash flows cash flows - - the initial outlay. the initial outlay.
NPV NPV - - I I
ACF ACFt t
(1 + k) (1 + k)
t t
n n
t1 t1
%%
Net Present Value Net Present Value
OO Decision Rule Decision Rule: :
OO If NPV is positive, If NPV is positive, ACCEP% ACCEP%..
OO If NPV is negative, If NPV is negative, RE1EC% RE1EC%..
NPV Example NPV Example
Suppose we are considering a capital Suppose we are considering a capital
investment that costs investment that costs $276,400 $276,400 and provides and provides
annual net cash flows of annual net cash flows of $83,000 $83,000 for four for four
years and years and $116,000 $116,000 at the end of the fifth year. at the end of the fifth year.
%he firm`s required rate of return is %he firm`s required rate of return is 15. 15.
NPV Example NPV Example
0 1 2 3 4 5
(276,400)
83,000 83,000 83,000 83,000 116,000
Suppose we are considering a capital Suppose we are considering a capital
investment that costs $276,400 and provides investment that costs $276,400 and provides
annual net cash flows of $83,000 for four annual net cash flows of $83,000 for four
years and $116,000 at the end of the fifth year. years and $116,000 at the end of the fifth year.
%he firm`s required rate of return is 15. %he firm`s required rate of return is 15.
NPV with the HP10B: NPV with the HP10B:
- -276,400 276,400 CFj CFj
83,000 83,000 CFj CFj
4 4 shift Nj shift Nj
116,000 116,000 CFj CFj
15 15 I/YR I/YR
shift NPV shift NPV
You should get NPV You should get NPV 18,235.71 18,235.71..
NPV with the HP17BII: NPV with the HP17BII:
Select CFL mode. Select CFL mode.
FLW(0)? FLW(0)? - -276,400 INPU% 276,400 INPU%
FLW(1)? FLW(1)? 83,000 INPU% 83,000 INPU%
%IMES(1)1 %IMES(1)1 4 INPU% 4 INPU%
FLW(2)? FLW(2)? 116,000 INPU% 116,000 INPU%
%IMES(2)1 %IMES(2)1 INPU% EXI% INPU% EXI%
CALC CALC 15 I 15 I NPV NPV
You should get NPV You should get NPV 18,235.71 18,235.71
NPV with the %I BAII Plus: NPV with the %I BAII Plus:
Select CF mode. Select CF mode.
NPV with the %I BAII Plus: NPV with the %I BAII Plus:
Select CF mode. Select CF mode.
CFo? CFo? - -276,400 276,400 EN%ER EN%ER
NPV with the %I BAII Plus: NPV with the %I BAII Plus:
Select CF mode. Select CF mode.
CFo? CFo? - -276,400 276,400 EN%ER EN%ER
C01? C01? 83,000 83,000 EN%ER EN%ER
NPV with the %I BAII Plus: NPV with the %I BAII Plus:
Select CF mode. Select CF mode.
CFo? CFo? - -276,400 276,400 EN%ER EN%ER
C01? C01? 83,000 83,000 EN%ER EN%ER
F01 1 F01 1 4 4 EN%ER EN%ER
NPV with the %I BAII Plus: NPV with the %I BAII Plus:
Select CF mode. Select CF mode.
CFo? CFo? - -276,400 276,400 EN%ER EN%ER
C01? C01? 83,000 83,000 EN%ER EN%ER
F01 1 F01 1 4 4 EN%ER EN%ER
C02? C02? 116,000 116,000 EN%ER EN%ER
NPV with the %I BAII Plus: NPV with the %I BAII Plus:
Select CF mode. Select CF mode.
CFo? CFo? - -276,400 276,400 EN%ER EN%ER
C01? C01? 83,000 83,000 EN%ER EN%ER
F01 1 F01 1 4 4 EN%ER EN%ER
C02? C02? 116,000 116,000 EN%ER EN%ER
F02 1 F02 1 EN%ER EN%ER
NPV with the %I BAII Plus: NPV with the %I BAII Plus:
Select CF mode. Select CF mode.
CFo? CFo? - -276,400 276,400 EN%ER EN%ER
C01? C01? 83,000 83,000 EN%ER EN%ER
F01 1 F01 1 4 4 EN%ER EN%ER
C02? C02? 116,000 116,000 EN%ER EN%ER
F02 1 F02 1 EN%ER EN%ER
NPV NPV I 15 I 15 EN%ER EN%ER CP% CP%
NPV with the %I BAII Plus: NPV with the %I BAII Plus:
Select CF mode. Select CF mode.
CFo? CFo? - -276,400 276,400 EN%ER EN%ER
C01? C01? 83,000 83,000 EN%ER EN%ER
F01 1 F01 1 4 4 EN%ER EN%ER
C02? C02? 116,000 116,000 EN%ER EN%ER
F02 1 F02 1 EN%ER EN%ER
NPV NPV I 15 I 15 EN%ER EN%ER CP% CP%
You should get NPV You should get NPV 18,235.71 18,235.71
Profitability Index Profitability Index
NPV NPV - - I I
ACF ACFt t
(1 + k) (1 + k)
t t
n n
t1 t1
%%
Profitability Index Profitability Index
t
NPV NPV - - I I
ACF ACFt t
(1 + k) (1 + k)
t t
n n
t1 t1
%%
PI I
ACFt
(1 + k)
n
t1
%%
Profitability Index Profitability Index
OO Decision Rule Decision Rule: :
OO If PI is greater than or equal If PI is greater than or equal
to 1, to 1, ACCEP% ACCEP%..
OO If PI is less than 1, If PI is less than 1, RE1EC% RE1EC%..
PI with PI with
the the
HP10B: HP10B:
- -276,400 276,400 CFj CFj
83,000 83,000 CFj CFj
4 4 shift Nj shift Nj
116,000 116,000 CFj CFj
15 15 I/YR I/YR
shift NPV shift NPV
You should get NPV You should get NPV 18,235.71 18,235.71..
Add back I: Add back I: + 276,400 + 276,400
Divide by I: Divide by I: / 276,400 / 276,400
You should get You should get PI 1.066 PI 1.066
Internal Rate of Return (IRR) Internal Rate of Return (IRR)
IRR IRR: the return on the firm`s : the return on the firm`s
invested capital. IRR is simply invested capital. IRR is simply
the rate of return that the firm the rate of return that the firm
earns on its capital budgeting earns on its capital budgeting
projects. projects.
Internal Rate of Return (IRR) Internal Rate of Return (IRR)
NPV NPV - - I I
ACF ACFt t
(1 + k) (1 + k)
t t
n n
t1 t1
%%
Internal Rate of Return (IRR) Internal Rate of Return (IRR)
n
t1
%%
IRR: I
ACFt
(1 + IRR)
t
NPV NPV - - I I
ACF ACFt t
(1 + k) (1 + k)
t t
n n
t1 t1
%%
Internal Rate of Return (IRR) Internal Rate of Return (IRR)
IRR is the rate of return that makes the IRR is the rate of return that makes the
PV of the cash flows PV of the cash flows equal equal to the initial to the initial
outlay. outlay.
%his looks very similar to our Yield to %his looks very similar to our Yield to
Maturity formula for bonds. In fact, Y%M Maturity formula for bonds. In fact, Y%M
is is the IRR of a bond. the IRR of a bond.
n
t1
%%
IRR: I
ACFt
(1 + IRR)
t
Calculating IRR Calculating IRR
Looking again at our problem: Looking again at our problem:
%he IRR is the discount rate that %he IRR is the discount rate that
makes the PV of the projected cash makes the PV of the projected cash
flows flows equal equal to the initial outlay. to the initial outlay.
0 1 2 3 4 5
(276,400)
83,000 83,000 83,000 83,000 116,000
%his is what we are actually doing: %his is what we are actually doing:
83,000 (PVIFA 83,000 (PVIFA 4, IRR 4, IRR) + 116,000 (PVIF ) + 116,000 (PVIF 5, IRR 5, IRR) )
276,400 276,400
0 0 11 22 33 44 55
(276,400) (276,400)
83,000 83,000 83,000 83,000 116,000 83,000 83,000 83,000 83,000 116,000
%his is what we are actually doing: %his is what we are actually doing:
83,000 (PVIFA 83,000 (PVIFA 4, IRR 4, IRR) + 116,000 (PVIF ) + 116,000 (PVIF 5, IRR 5, IRR) )
276,400 276,400
%his way, we have to solve for IRR by trial %his way, we have to solve for IRR by trial
and error. and error.
0 0 11 22 33 44 55
(276,400) (276,400)
83,000 83,000 83,000 83,000 116,000 83,000 83,000 83,000 83,000 116,000
IRR with your Calculator IRR with your Calculator
IRR is easy to find with your IRR is easy to find with your
financial calculator. financial calculator.
1ust enter the cash flows as you did 1ust enter the cash flows as you did
with the NPV problem and solve for with the NPV problem and solve for
IRR. IRR.
You should get You should get IRR 17.63! IRR 17.63!
IRR IRR
OO Decision Rule Decision Rule: :
OO If IRR is greater than or equal If IRR is greater than or equal
to the required rate of return, to the required rate of return,
ACCEP% ACCEP%..
OO If IRR is less than the required If IRR is less than the required
rate of return, rate of return, RE1EC% RE1EC%..
IRR is a good decision IRR is a good decision- -making making
tool as long as cash flows are tool as long as cash flows are
conventional conventional. . ( (- - + + + + +) + + + + +)
Problem: If there are multiple Problem: If there are multiple
sign changes in the cash flow sign changes in the cash flow
stream, we could get multiple stream, we could get multiple
IRRs. IRRs. ( (- - + + + + - - + +) + +)
IRR is a good decision IRR is a good decision- -making making
tool as long as cash flows are tool as long as cash flows are
conventional conventional. . ( (- - + + + + +) + + + + +)
Problem: If there are multiple Problem: If there are multiple
sign changes in the cash flow sign changes in the cash flow
stream, we could get multiple stream, we could get multiple
IRRs. IRRs. ( (- - + + + + - - + +) + +)
0 1 2 3 4 5
(500) 200 100 (200) 400 300
IRR is a good decision IRR is a good decision- -making making
tool as long as cash flows are tool as long as cash flows are
conventional conventional. . ( (- - + + + + +) + + + + +)
Problem: If there are multiple Problem: If there are multiple
sign changes in the cash flow sign changes in the cash flow
stream, we could get multiple stream, we could get multiple
IRRs. IRRs. ( (- - + + + + - - + +) + +)
0 1 2 3 4 5
(500) 200 100 (200) 400 300
Problem: If there are multiple Problem: If there are multiple
sign changes in the cash flow sign changes in the cash flow
stream, we could get multiple stream, we could get multiple
IRRs. IRRs. ( (- - + + + + - - + +) + +)
We could find 3 different IRRs! We could find 3 different IRRs!
0 1 2 3 4 5
(500) 200 100 (200) 400 300
1 2 3 1 2 3
Summary Problem: Summary Problem:
Enter the cash flows only once. Enter the cash flows only once.
Find the Find the IRR IRR..
Using a discount rate of 15, find Using a discount rate of 15, find NPV NPV..
Add back I and divide by I to get Add back I and divide by I to get PI PI..
0 1 2 3 4 5
(900) 300 400 400 500 600
Summary Problem: Summary Problem:
IRR IRR 34.37. 34.37.
Using a discount rate of 15, Using a discount rate of 15,
NPV NPV $510.52. $510.52.
PI PI 1.57. 1.57.
0 1 2 3 4 5
(900) 300 400 400 500 600